Is China Reversing Its ‘Uninvestable’ Image?
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Welcome to Merrin Talks Money, the podcast in which people who know the markets explain the markets. I'm Merrin Somerset Webb. This week, I'm speaking with Dale Nichols, portfolio manager of the Fidelity China Special Situations Trust. As we have discussed many times this year already on this show, the spell around American exceptionalism appears to have broken. Investors are looking elsewhere for places to park their money, and one of those places looks like China.

So we thought it'd be a good idea to get on a China expert, which Dale is, get his insights on what he's seeing on the ground, see what he makes of the various policy measures in place, think tariffs, and what companies he thinks have the greatest upside potential. Dale, welcome to Merindog's Money.

Thanks, Maren. Great to be here. Okay. China is such a big topic, it's almost impossible to know where to start. I suppose that the first thing to say is that very few people are really invested in China in any significant way. It's a very small part of the world index. Its percentage of the world index in general, nowhere near matches its share of GDP. So what, about 20% of global GDP and what, 3% of the indices? Yeah, around there.

Yeah, so that's a huge mismatch. And most people would look at that and say, well, that makes a lot of sense because China is more or less uninvestable for an institutional investor and retail investors tend to clear of it.

And if you look at the news over the last week, you think to yourself, well, that kind of makes sense. So politically, you've got China and the U.S. now really involved in a fairly nasty row over trade. Everyone accusing everyone else of violating, seriously violating, say China, absolutely violating, totally violating, says Trump. And then you had the U.S. defense secretary out the other day saying the threat China poses is real and it could be imminent.

You look at the polls and you see that, depending on who you listen to, between 35 and 40 percent of Americans class China as an enemy. And so you look at that and you think, well, for starters, given that political background, ignoring everything else, given that political background, when on earth would I put money into China? So let's start there. How bad do you see that political conflict moment?

If we're talking about the political element, I think you're focusing more on the geopolitical side. And there's no question that, you know, this friction that we've seen between China and the US is going to be with us for a long time. It's sort of a natural part, I think, of sort of China's rise. So I think that's, you know, that's something we're going to have to have to deal with. I do feel that people are sort of becoming more comfortable with that.

So let's just go right back. When you say it's a natural part of China's rise, what do you mean that that economic challenge to the US will naturally cause geopolitical conflict? Absolutely. What's often missed in the discussion when we talk about China's competitiveness is the element of scale.

obviously a huge population. A lot of companies are leveraging that domestic population, taking that scale offshore. So the companies are extremely competitive. It's obviously not just scale. We're going to talk about China competitiveness. We shouldn't also ignore the fact that companies in China have basically compounded R&D spend at about 20% for the last decade. So I think that's a big part of the story. But I do feel that the scale element

is often understated. Now, we shouldn't be surprised, I think, that China is so competitive in EVs when they're producing 60% to 70% of the world's EVs. And obviously, the share of the supply chain, you know, more upstream is even higher. So,

I think that's sort of an important backdrop to keep in mind. Yeah, we'll come back to all that kind of thing. I just want to keep it for the first bit relatively high level. Does it concern you?

that the American administration is now talking in clear terms of conflict and threat and enemy and all these words that added to the endless tariff difficulties make it feel like a non-confrontational relationship for the last 20 years. But now it really does feel kind of dirty.

Yeah, but I think at the same time, there's a recognition of just how interconnected the systems are. Having Scott Bessant come out and say, there's not going to be decoupling. There's a recognition of just how interwoven the economies are. China's producing 30% of the world's goods. You can't just decouple. The impact is too great. So I expect there's going to be friction. There's going to be a high level of competition.

But I think at the same time, there's a recognition that both are going to develop. And where do you see these trade talks ending up then? Where do you think we'll settle? We'll see. And how? You know, I would expect, you know, I would expect, you know, probably going to see tariff levels towards China, if I had to guess, probably around the 30% level. But it'll probably vary by sector. Yeah, I wouldn't be surprised if I had, if I was a betting man, I'd say that's probably where, you know, things end up.

You are a betting man. That's what fund management is, right? Right. But I do think, again, it's important to keep things in context. First of all, I invest in companies. I'm sort of evaluating things at the stock level. I do feel, from a market's perspective and as a bottom-up stock picker, it often gets overstated. If you look at U.S. sales as a percentage of total revenues of MSCI China, we're talking at about 3%.

So, you know, it's not huge exposure in terms of the companies. The domestic market is just, you know, so much more important to the companies.

Obviously, with tariffs, there's going to be a greater economic impact. The export sector is still significant, but I do feel it's often overstated. I think it's also important to keep in mind that Chinese companies have obviously dealt with tariffs before. They've come through Trump 1.0 and the first tariffs that were implemented. China continued to gain global market share through that.

So I think, and again, this is reflected in my discussions with companies as well, the ones that do have exposure to the US are pretty well prepared. And as someone who looks beyond China as an investor as well, if there's a

If there's a group of companies that I would rely on for adaptability, resilience, et cetera, it'd probably be the Chinese group of companies to come through this. Another thing that is, I think, perhaps underappreciated in a lot of sectors, the whole supply chain is Chinese, is Chinese companies. So in those cases, when we talk to companies, no one's worried about market share loss through tariffs. The discussion all comes down to

It's around price elasticity. What happens to volumes when prices go up 30%, 40%? That's the type of discussion. And obviously, a lot of them are thinking about if they were to invest in the US, what would that involve? And it's a tough decision for them because a lot of the time, there is no supply chain. So they're starting at a very low level. It's going to take years.

And, you know, there's a good chance the political environment might be different by the time that capacity comes online. So that's sort of the discussions that we're having with companies at the company level. And outside that, the macro background involving the US and tariffs, etc., the macro situation in China, we read a lot about the stunningly high debt level, the aging population, income and wealth inequality, property downturn, property downturn being the big one, of course. Right.

All those elements, how serious a problem are they for the listed companies in China?

Sure. Obviously, the economic backdrop is important. Again, I think it's important to keep things in context. We're still talking about 5% growth in a global context. It's not that bad. And I think looking forward, it's fair to assume that the consumption part of that grows faster. So it's not a particularly bad environment. You touched on property.

It's definitely been a significant drag for the economy over the past few years. My sense is that we're definitely past the worst part of that adjustment. I'm particularly focused on... The property market is definitely not going back with the heady years of huge growth. I'm very focused on what's happening to property prices because I think that's a key factor behind the mindset of the consumer.

The consumer has definitely underspent through COVID, post-COVID. We've had a significant increase in deposits. Consumer confidence is low. I'm very focused on that, but actions have been taken. You need to keep in mind that there was a period of significant property tightening. That's mostly unwell now, but there's still growth.

There's still things like price caps and that sort of thing in certain areas. So you've seen significant action to support the property sector, but I expect there's definitely more to come. I do feel, particularly from September last year, there's a greater recognition amongst policymakers of just what a drag that has been. And we're starting to see signs of stabilization. So looking at that price element, if you look at first tier cities,

In, I think, six of the last eight months, you've had price increases. And there's signs of stabilization in the primary market there as well. So I think we're sort of on track at some point, but you're on your prices to improve. And once that stabilization continues, you have to think that there's more potential for that

very sort of low levels of consumption to start to improve. Okay. So this is the – sorry, carry on. I was just going to finish the point on property. I mean, as I said, that's been a major drag. The peak of the drag is probably this year as well. And again, it will still be a drag, I expect, but it will be less than it has been in the past. So, you know, I think it is a pretty good case for things to slowly improve.

And again, we get the sense that the government is very much focused on driving that. They're looking at the potential drag that tariffs can be. And I think

rest assured that there's going to be more coming. Although we have heard for, we do hear year after year after year, that the Chinese government is very, very focused on shifting the Chinese economy away from being a pure export-driven model towards being more of a consumer model. And we do hear this constantly, and we don't necessarily see it happening. There's an awful lot of wishful thinking and not necessarily the big macro moves that everyone is after. True. I mean, we haven't seen the sort of

you know post-covid stimulus that you've seen in a lot of the west uh but you know again the sense we have from from listening to the policymakers is an increasing awareness of the need to to do more um and i think we see we will see more to come and again i think that property element is important and the fact that we're you know seeing things start to stabilize i think is a

is a good positive sign. Let's talk then a bit about the market. I mean, the long-term performance of the Chinese stock market, if you look at MSCI China, is pretty awful, really. And you've had a slightly better year this year, but nonetheless, not great. And partly the things that we've been talking about, the macro stuff, but...

Also, the fact that you've got a very large section of the market that is state-owned enterprises, that you have relatively low margins, that you have a sense that an awful lot of Chinese companies are more focused on market share than profits, that possibly their operations could be more driven by sales.

state ambition than by corporate ambition. And those are some of the elements that maybe have led it to underperform and still be remarkably cheap, but cheap relative to global markets, cheap relative to the US, should I say. The state-owned portion of the market has declined. Yeah. So there's been a real market change in the makeup of the market over the past five to 10 years. That SOE proportion has definitely fallen.

You know, it's no longer a market that is completely dominated by energy banks and telcos. The private sector has become a much bigger part of the market, but importantly, the biggest driver of the economy as well, the biggest driver of growth, biggest driver of employment, et cetera. And, you know, it's worth noting we've had the creation of

of whole new sectors. If you look at what's happened in the auto space with the EVs that we've touched on, this is obviously mostly driven by private companies. So that's where the majority of the focus is for us. We don't ignore the SOEs, particularly when obviously valuation is a big factor. So there can be good opportunities within the SOEs, but

If we're looking at five to 10 years, it's the private companies that are going to be

are going to be driving the growth. Okay. And what might close out? Who's going to come into this market? Who will the buyers be? Are you seeing a shift in the institutional mindset? Institutional investors are looking at their allocations and saying, well, we're exposed to the US. We've got this giant economy over there. We've slightly been alerted to by the tariff argument. And maybe it's time to go above 2%, 3% in China. Because, of course, an awful lot of institutional investors and global funds, they're underweight, even the index allocation to China, aren't they?

Absolutely. Well, first of all, you would hope it's the domestics. So you have the big domestic institutions that are clearly investing in the market, but you would hope that the individuals can come back to the market. We've seen an increase in the number of brokerage accounts and that sort of thing over the last year or so. So hopefully that will be a driver.

You know, on the more international stage, as we've talked about, we're starting from a very low point. I think, you know, sort of commentary out of the US that, you know, we're not decoupling. I think there's a recognition that China is investable. If we think about where weights are, you know, there's good potential, you know, for that to move up. You know, we talked about that discount relative to the US and what's driven that.

If you think about things like policy certainty and things like that, obviously, we've been through a very volatile period in terms of policy coming out from the US. China is on the fifth year of its 14th five-year plan. There's a fair bit of certainty about generally where policy is going. Over time, if we're not decoupling, hopefully there's a recognition of that stability that

that can start to bring what is still a pretty significant discount back.

Yeah. Let's talk then about the kind of companies that you're looking for. I mean, it's obvious to say it, but the Chinese market should be something of a stock picker's paradise, right? It's not necessarily a market that the passive investors should go for again, because you might get stuck with a whole portfolio full of SOEs, etc. So if you are an active manager going into this market, I'm slightly assuming you end up with a bias to mid and small cap companies. How do you choose? Where do you look?

out of the work yeah yeah absolutely i completely agree with you that you know it's as as a bottom up stock picker you've got you know a huge range of choices you've got massive change on the ground the winners and losers losers are being are being sort of separated all the time there's a process of consolidation that's happening and yet you know you have this market that's driven by macro headlines geopolitical headlines etc so look i'm a stock picker it's uh

It's very good. We spread the net very wide in terms of what we're looking for. But I do tend to focus on those areas of the economy that we know are going to be bigger parts if you're looking at five to 10 years. I talked about the consumer. I think that particularly just in the mass area, I think the investment setup is really strong. You've got companies that have been sold off over the concerns that consumer has been weak.

But as we've mentioned, we've got a consumer that has underspent for many years. As a result of that, they've got very strong balance sheets and stimulus is coming. And I'd be contrast that with perhaps other markets in the West where you may have a consumer that's more extended and austerity is coming.

I think the setup for the consumer is actually quite good. I focus on areas like some of the staples. You talked about increased competition. If you look at an area like beer, I think competitive intensity has definitely come down. Natural premiumization, they're getting pricing. They've done a lot in terms of rationalizing factories and things like that.

And that capital return story is very alive and well. Sportswear, you've got, look at that spend per capita on sportswear in China. It's a fraction of what we see in the West. Well, let me ask you before you move on to anything else about the luxury goods sector in China. And that one of the things we've been reading about a lot recently and the decline of interest in Chinese consumers in the big Western luxury brands and their shift back to more of a sense of domestic luxury. Are you seeing that?

Yeah, I mean, if you're talking true luxury, I mean, this is a space globally that's dominated by the European. So, you know, if you were to focus on luxury in China, there's not many ways to play it. I'd say, you know, the strongest luxury brand in China is probably Maotai as the top Baizhou brand. So, you know, it's not a big space if you focus purely on luxury. Obviously, there's some upper market brands there.

But, you know, the real opportunity, I think, is much more in mass. Mass market. Yeah. Uh-huh.

Yeah. Okay. And what about the, I suppose when we look at China at the moment, we tend to see innovation, don't we? We see the biggest producers of EVs. We see this extraordinary progress in AI, the unexpected catch up. And we see the huge leadership in solar panels and renewable energy. Also, of course, a much faster shift to using nuclear energy than the rest of us. So we see this uproar.

ongoing innovation and the whole idea that even a few years ago, people would be writing about how China was all very well, but really they're just copying. And that story is over. Stunning innovation in China now. Absolutely true. Yeah, absolutely. It's something that we see daily. I talk about how companies are investing and you're seeing that coming through just in improving competitiveness.

which is feeding into price and power for companies. So yeah, I mean, that's definitely a big trend. I have a pretty big bet in the trust in industrials. And there's still room for that to play out. If you look at an area like robotics, up until a few years ago, the top four players were all foreign, the top sort of the big four. Now, two of those are now local, but

There's still room to make share gains domestically. What are those local robotics companies? Companies like Estern and Innovance are companies that are pushing up into that robotics space. A lot of them, like Innovance, is doing some of the other components as well. There's definitely room to grow there. That whole EV chain that we talked about is very exciting.

They've got this great shift to high quality growth. One of the problems that people have felt with stock markets over the last four or five years, last decade maybe, is that an awful lot of the growth takes place off market before companies list, right? So the real growth, the real innovation, the real excitement is in private markets, not public.

Do you feel that in China as well, that maybe the listed stocks don't necessarily represent the extent of the innovation in the economy? It's hard to get real access. Yeah, no, it's a very fair point that globally companies are coming to market later. You've got some huge private companies. Luckily for us, we're quite active in the private space as well. How active are the trusted privates? So it's just over 10%.

And what else is in there? I mean, how do you find those? I mean, that's even harder, right? Finding a good listed stock in thousands of listed companies is hard enough, but going out and looking for private companies on the ground in China, how do you do that?

We leverage our public team. So our public team is sort of obviously focused on the public listed stocks, but they can look at the larger private companies as well. But we have people that are purely focused on private as well. I mean, it's an area that we've expanded out. The majority of potential opportunities that we're finding now is proprietary. So years back, we were probably more reliant on the banks, but

But these days, it's very much the proprietary opportunities that we're seeing. By tense, we added to in the secondary market last year, we think, at a single-digit type of valuation. And that's with the international business losing money. So the TikTok part of the story is actually a drag on earnings. And very much, we feel not factored into the overall story. And

Again, I feel it's probably another area where the US exposure is somewhat overstated. I mean, it's not insignificant. They've got 170 million or so users in the US, which is about half the population. But TikTok has over 2 billion users. And how do you exit a position like that? I mean, are you hoping that the IPO market will come back?

And you will be able to exit that in the public markets. Yeah, IPO will be the main form of exit. You know, there could be potential trade sales and that sort of thing in the future. But, you know, you've got to assume that, you know, IPO is going to be the main market.

the main way to exit these positions. Well, a lot of the things that you've been talking about sound like they might give some hope to those worrying about how countries such as China will cope with their demographic disasters. Well, some may think them disasters. I mean, China is one of the first places to start seeing actual falls in population, right? Which is quite a thing. Sure.

How do you see that unfolding? I mean, it is extraordinary in that we've never really... I was writing the other day about how the world is effectively peak humanity at the moment. We may already have hit it given how incorrect most forecasts of fertility are. We may already be at peak humanity, which is an extraordinary thing for us, right? We are living for the first time ever possibly topping out of the global population. And you can see it in action in some European countries. You can see it in action in Japan. And you're beginning to see it in action in China.

What happens? How does this work? I mean, no one knows how it works, right? Because we haven't seen it before. But lots of the innovations that you've been discussing feel like they would feed very well into a declining population or certainly a heavily aging and declining population. Yeah. I mean, it's a challenge. And as you stated, it's not just China, obviously Europe, Japan, you know, clearly have these challenges. I don't feel like it's

Something that really changes the outlook for a lot of stocks if we're looking out back to 10 years in a big month for a lot of companies. There are things that China can do. Obviously, it's a potential raising of the retirement age. There's still the urbanization story in China. That's still something that's definitely going to play out.

You know, you would have heard the potential for things like hookah reform, household registration reform, still got, you know, 280 million or so workers that aren't afforded the same rights as others. So still a lot of room to, you know, address these challenges. And I think that can be, you know, definitely supports for consumption as well.

One of the things that is really required for a big expansion of the consumer economy in China is a bigger welfare state, right? One of the reasons why it's very hard for people to spend and feel confident in spending, particularly in a declining population environment, is the lack of a real safety net. So obviously you want to save as much as you can if no one else is going to take care of you. So surely the biggest step forward to creating a consumer economy would be the creation of a

genuine, more all-encompassing welfare state. Yeah, I think all-encompassing is the right word. It's there, but it needs to be, you know, there's room for it to be bolstered and the things that we've talked about, about potential reform in household registration and that sort of thing, you know, can be boosted for that. And I think you've got to assume that those types of things are on the radar when you're thinking about how we can support the outlook for the consumer going forward. Okay, what would make you feel...

less optimistic about the Chinese market. We've talked about all the reasons to be optimistic about long-term returns and the things that are exciting, particularly innovation, et cetera. But what would make you worried? Make you think, actually, maybe this is more of a trade than a long-term investment, which forces how a lot of people do see the market. Right. I think what would make me more negative, obviously, what happens with property, as I've said, is key. So

a sort of a declining commitment to continue to drive that recovery would be a concern. I think also if we saw a ramp up in domestic regulation,

That would be a concern. Obviously, we've been through a period where we did see that pretty significant ramp up in domestic regulation. We feel we're definitely, the focus is very clearly now on growth. But if for whatever reason we saw, I'd say regulation move strongly in the other direction, that would definitely be a concern for us.

On the flip side, what would make you want to shout from the rooftops, everyone get your money in now? It would just be a continuation of a sort of steady recovery. I don't think I'd be that bullish if we sort of had huge stimulus infrastructure-type packages of the past. But just sort of increasing support for the consumer, gradually improving consumer sentiment,

And if we're sort of able to draw on some of those savings and things gradually recover, that would be great. Obviously, a more stable global environment. That would do it for everybody? That would be nice to have. Tell us the story of the most exciting stock you've added recently. I would say it's in my top 10, but if you look at a company like Herci, like LIDAR, they're

extremely competitive in that space and obviously a very strong market position in China, but they're going offshore making big wins globally as well. It's hard to see how that competitive position reverses. Let's face it, Autonomous is really just getting going. We're at the starting point. Last question then, Dale. What are you reading at the moment?

It is not investment related. It's a book called The Lion Tracker's Guide to Life. And the author, Boyd Barty, if you've ever heard him talk, he's a fantastic storyteller. And I've heard many of his stories, but hadn't read the book yet. So I'm sort of working through that. I highly recommend it. There's some great stories and I think probably lessons for life in there as well. Brilliant. Thank you very much. And Del, thanks for joining us today. That was fascinating. Thanks, Merit. Great to chat.

And special thanks to Dale Nichols.

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